China looks to deepen ties with Latin America

China's president, Xi Jinping, has embarked on a week-long visit to Latin America that will include state visits to Ecuador, Peru and Chile. Mr Xi's trip comes immediately on the heels of a US presidential election that has called the future of US-Latin America relations into question, and highlights China's emergence as a key trade and investment partner for the region. China has appeared open to the possibility of expanding its (currently extremely limited) array of free-trade deals in Latin America, at a time when major economies in the region, such as Brazil and Argentina, are keen to pursue free trade—and at a time when the chances of developing deeper trade links with the US and Europe appear increasingly slim. For Latin America, a key priority in the development of deeper relations with China will be the diversification of trade in order to reduce reliance on commodity exports.

Mr Xi's visit to Latin America will be his third since taking office in 2013. He has already visited the region's three largest economies (Brazil, Mexico and Argentina), and a number of countries in the Caribbean and Central America. His latest visit will take in some of the region's key commodity exporters—and key trade and investment partners. For all three countries on Mr Xi's itinerary, China is the largest foreign direct investor. Peru and Chile are also two of only three countries in Latin America to have free-trade agreements (FTAs) in place with China (the other is Costa Rica).

Trade is likely to be high on Mr Xi's agenda. In Lima, Peru's capital, he will attend the summit of the Asia-Pacific Economic Co-operation (APEC), a forum for promotion of growth and integration among its 21 Pacific Rim member states. There has been speculation that Mr Xi might use the occasion to push for an Asia Pacific free-trade deal to replace the Trans-Pacific Partnership (TPP), a US-backed trade pact with Asian and Latin American Pacific Rim countries, including Japan but excluding China, which appears all but dead in the aftermath of the US presidential election on November 8th. China has in the past pushed for a Free-Trade Area of the Asia-Pacific (FTAAP) as an alternative to TPP.

For Latin America, deeper trade links will certainly be a priority, but trade and investment diversification will be equally important. A slowing of import demand in China since 2015 has had severe consequences for Latin America and raises important questions about economic relations between China and Latin America going forward.

Trade and investment ties deepen

In the past 15 years trade between China and Latin America has grown almost twentyfold. From around US$5bn in 2000, Latin America's exports to China totalled US$104bn in 2015. Inflows of foreign direct investment (FDI) from China into Latin America and the Caribbean were slower to take off, but have also risen markedly in the past five years, albeit from a low base. According to the Heritage Foundation, a US think-tank, Chinese FDI into Latin America totalled US$84bn between 2010 and 2015.

Increased trade and investment flows from China have undoubtedly had a beneficial impact in the form of increased growth in the past decade. But they have also left the region vulnerable to the inevitable slowdown and rebalancing of China's economy that has begun in the past two years, which has seen a sharp adjustment in China's demand for imports and in global commodity prices.

The data are stark. According to The Economist Intelligence Unit's estimates, growth in volumes of goods and services imports fell from 9.2% in 2014 to 1.3% in 2015. In US dollar terms, China's imports from Latin America fell by almost 20%, to US$103bn, from an all-time peak of US$126bn the year before. The direct impact of weaker demand growth from China, and its indirect effect on Latin America in the form of lower commodity prices, has forced difficult, ongoing policy adjustments, particularly for South America's commodity exporters.

On aggregate, the region's fiscal revenue has fallen by 4% of GDP in the past five years, driving the public debt/GDP ratio back up above 50% and necessitating a substantial tightening of fiscal policy in all of Latin America's large economies. Combined with a retrenchment in investment across the region, and its knock-on impact on private consumption, the result has been two extremely disappointing years for the economy: in 2015 real GDP grew by just 0.1% and in 2016 we estimate a contraction of 0.4%.

Growing imbalances

The region's economic woes are at least partly the reflection of a failure by policymakers to take advantage of the commodity supercycle of the past decade to implement domestic structural reforms that could have set the stage for more diversified, competitive and productive economies. But a closer look at the data highlights elements of the trade and investment relationship between China and Latin America that are problematic.

Figures from the UN Economic Commission for Latin America and the Caribbean (ECLAC) indicate that around three-quarters of the region's exports to China are made up of just four commodities: oil, copper, iron ore and soybean. Meanwhile, reflecting Latin America's relatively high per head incomes, along with China's low production costs, China exports a high proportion of low- and high-technology consumer goods to Latin America. This process of exporting natural resources to China and importing higher value added manufactures has produced large and growing trade deficits in Latin America for most of the past decade. Weak commodity prices in 2015 amplified this trend, causing Latin America's trade deficit with China to quadruple, to US$26bn. A similar pattern is evident in China's financing and investment role in the region, which has been centred either directly on natural resource industries in order to secure supply, or on associated infrastructure to facilitate transport.

Beyond One Belt One Road: a plan for Latin America

Policymakers in China and Latin America are clearly aware of the challenges posed by the structure of trade and investment between the two partners. In a May 2015 visit to Latin America, China's premier, Li Keqiang, noted that "Latin America should not limit itself to being a 'global supplier' of primary products, nor China being a 'world factory' of cheap products forever". Latin America has not been a beneficiary of the Chinese government's grand "One Belt One Road" infrastructure project involving China's closer neighbours in Eurasia and North Africa. But over the course of recent official visits, China has set out new priorities for engagement with the region (via trade, investment and finance) in priority sectors, including energy and resources, infrastructure construction, agriculture, manufacturing, logistics, and scientific and technological innovation.

If implemented to their full potential, the plans, which set out to dramatically increase trade and investment while also altering the composition of both countries' exports, could have transformative effects for Latin America. At just over 2% of GDP, investment in infrastructure in Latin America and the Caribbean is currently low, both by comparison with the rest of the world and relative to its needs: ECLAC estimates that, in order for the region's infrastructure network to meet projected demands and not become a constraint on long-term growth, more than 6% of GDP should be invested in infrastructure in 2016‑20. Foreign investment is sorely needed to bridge this gap, given the region's public spending constraints.

Latin America also lags in research and development (R&D), and would benefit immensely not only from FDI into higher-tech industry by Chinese firms, but by associated technology transfer and experience of China's successful drive to increase innovation and educational outcomes. At present, Latin America's investment in R&D is estimated at just 0.5% of GDP, well below the global average of over 2% of GDP. China also invested just 0.5% of GDP in R&D in the mid-1990s, but has since overseen a steady increase, to 2% of GDP currently.

Importantly, China has placed a fresh emphasis on the role to be played by business. Until now the presence of private Chinese enterprise has been extremely limited, reflecting the dominance of China's state-owned enterprises in key natural resource sectors, while outward FDI into China has been practically non-existent (with a few noteworthy exceptions, such as Embraer, a Brazilian aerospace conglomerate). This has not only limited the possibility of technology transfer, but hindered the deepening of business links and the diversification of exports.

A challenging reform agenda

Trade and investment diversification will depend in part on China's own economic transition and its capacity to follow through with stated commitments. But improvements will also depend on the ability of Latin American policymakers to raise the competitiveness of their continent's output via a comprehensive—and politically difficult—programme for structural reform. China has stated that it is ready to sign more FTAs with the region to deepen business links, but that governments need to work to improve service efficiency, bring down business costs and create an enabling business environment for companies, tasks which will require politically difficult reforms to tax and regulatory systems, the labour market and the framework for public-private partnerships. Despite all these challenges, however, it is clear that Latin America is important to China, and fresh trade and investment announcements are expected to emerge from Mr Xi's latest visit to the region.